Can Low Oil Cause a Recession?

Every rally in crude prices has proven to be short lived and the oil crash has dragged down the entire stock market. Crude price is down over 25% this year already. This has pulled down the shares of energy companies in the S&P500 index by 13%, which in turn has led to an overall decline of 9% in the index.

Although oil has staged a comeback over the last few days and is up considerably from its multi-year lows, it is still hovering around $30 per barrel. While many investors believe that low oil is good for the U.S. economy, it is not true and can further deteriorate the market and can cause a recession.

The oil market is currently plagued with oversupply and with Iran pumping more oil into the market, prices could stay under $30 for the foreseeable future.

When crude price was high, many banks sanctioned loans to energy companies to finance drilling in regions like North Dakota, and Texas. As a result, the total outstanding debt in the energy sector is estimated to be worth over $500 billion.

With oil trading near $30 per barrel, the cash flow across the sector is slowing down at a drastic pace. As a result, it is becoming harder for the companies to pay back their loans. With many companies struggling to survive amid the oil crash, it is certain that a major portion of the $500 billion debt will remain unpaid.

Big Wall Street banks like JPMorgan Chase, Citigroup, and BofA have all had to write down the value of energy loans. According to a report by JPMorgan, three years of oil at $65 per barrel would probably lead to a 25%-40% default rate across the energy junk bond market. However, with oil significantly below the $65 per barrel mark and expected to stay there for quite some time, the default rate could rise drastically. Hence, oil price implosion may be good for consumers in the short-term, but it can also cause a recession.

Conclusion

Over the weeks, I have given several reasons why I am bearish on the U.S. stock market. Due to my bearish stance, I have recommended investors to increase their short positions. The S&P 500 index is already down almost 10% in 2016, but it can continue falling over the next few months. Amid ForEx headwinds, over $1.2 trillion worth of unpaid student loans, implosion of oil prices, and bursting of the China bubble, the chances of recession are high and investors should prepare for it following a long-short strategy.